Saturday, March 14, 2009

"I don't feel the sickness yet, but it's in the post. That's for sure. I'm in the junkie limbo at the moment. Too ill to sleep. Too tired to stay awake, but the sickness is on its way. Sweat, chills, nausea. Pain and craving. A need like nothing else I've ever known will soon take hold of me. It's on its way."

I believe Mark "Rent-Boy" Renton's words from the seminal movie Trainspotting could just as easily be attributed to any bank in the U.S., the vast majority of which are about to hit the lows of bailout addiction, however, without the benefit of a methadone clinic waiting on the other side of the heroin/bailout trip.

Among the various life-support and addiction-enabling systems designed during sleep-deprived brainstorming sessions in some dimly-lit small office in D.C., in the triage that was the post-Lehman financial world, was the FDIC'sTLGP (Temporary Liquidity Guarantee Program). The program, which became effective on October 14, 2008 and had an automatic opt-in clause for all participants, had the purpose of facilitating the issuance of senior unsecured debt at a time when credit financial markets had frozen and not a single bank was able to raise debt at reasonable rates. Many have speculated that of all alphabet soups designed to stabilize the financial system, the TLGP (especially in parallel with the other two liquidity-guaranteeing programs, the TAF and CPFF) has had by far the most pronounced positive impact: as banks can only function properly if their cost of capital is lower than the rate at which they lend out funds, finding a means to achieve cheap funding in the term markets was of life or death importance to banks. Furthermore, the TLGP being open only to Bank Holding Companies, was one of the reasons for the demise of the "old model" and the transition of such iconic investment banks as Goldman Sachs into BHCs (see here for a full list of terms of the TLGP). The importance of the TLGP is further underscored by the amount of FDIC-guaranteed debt issuance by financial institutions: over $300 billion of term financing has been raised by banks since the TLGP's inception with only 2 non-TLGP issues having been completed.

The banks' addiction to the TLGP is perfectly understandable as by using the explicit guarantee of the U.S. when issuing debt, banks do not subject themselves to having to compensate investors for taking on objectivebank risk (subordinated bank CDS levels imply term interest rates multiples higher than rates at which TLGP issues come to market). However, like every addiction, the longer it continues the higher the likelihood we will all end up with just one more dead, zombied junkie.

It is unclear how credit markets would function (if at all) in the absence of guarantees: the longer liquidity guarantees remain in place, the harder it will be to remove them and the more damage they will do to undermining what little private market discipline remains. And while banks will be happy to suckle on the FDIC teat for ever, the latter is already approaching a degree of distress where even deposit guarantees (as measured by Deposit Insurance Fund reserves) will soon be impossible. It is against this backdrop, that Senate Banking Committee Chairman Chris Dodd is seeking to be the ultimate enabler to the financial system. In a little noticed bill submitted on March 5 entitled the Depositor Protection Act of 2009, Dodd is seeking to increase TLGP-guarantor FDIC's $30 billion Treasury borrowing limit up to $500 billion. While on one hand, this action could be seen as the preparation for an ultimate bank failure, on the other hand, the funds thereby released will make sure that the addiction of the system to cheap money at the expense of market efficiency (and taxpayer cash of course) will persist, and eventually result in the virtually guaranteed overdose by the narcomaniac system.

Having FDIC's Cake And Eating It Too

The FDIC would likely be more than happy to perpetuate the image of all being well in its bid to restore systemic confidence (which is after all the heart of the problem), if it weren't for one small snag: the FDIC is on the verge of insolvency. At its heart, the FDIC is an insurer of deposits. It does this not so much with actual cash which would pay off depositors if there were a global run on the bank (which is negligible when compared to the total size of roughly $5 trillion in deposits), but by being a symbol of the U.S. guarantee to protect its depositors. After the money market fund broke the buck in late September, the FDIC had its job cut out for it, yet it did what it could, primarily by increasing the depositor insurance amount from $100,000 to $250,000 until December 31, 2009, to restore some confidence. However, because since then the FDIC's core role has become diluted due to its bank issue guarantees under the TLGP, the actual cash guaranteeing individual deposits has dwindled.

The heart of the FDIC depositor guarantee program is the Deposit Insurance Fund (DIF), which is actual cash set aside to, as the name implies, insure deposits. Yet recent data indicates that for the quarter ending December 31, the DIF has dropped to a staggeringly low number of only $19 billion, and the DIF reserve ratio (ratio of funds in the DIF to total insured deposits) was just 0.4% of total insured deposits, much lower than the statutory minimum ratio of 1.15%. Below is a graphic representation of the DIF reserve ratio over the past 4 years: based on the number of Q1 bank failures it is likely safe to assume that at this moment this ratio is significantly below the year end number of 0.4%.

The declining DIF is a scary prospect for the FDIC: after all, if the insurance money disappears (through a thousand small cuts by subsidizing all those bank failures which we read about every Friday night, or one massive cut such as the failure of a Citi or a BofA, which would immediately wipe out the DIF), even the implicit guarantee of depositors assets will be lost, leading the an instantaneous $5 trillion run on the bank.

The most recently disclosed amount in the DIF of $19 billion was an almost 50% reduction from the $36 billion at the end of September, and seeing how there have been 17 costly bank failures already year to date (all else being equal) it is easy to see how the FDIC is bleeding cash hand over first (while it would not surprise me at all if the reserve ratio was 0, or even negative, at this moment given all the recent activity to shore up funding, I will not hypothesize about this as the last thing I want, is to be accussed of causing a mass panic).

All these considerations have forced the FDIC to propose increasing the fees it currently charges TLGP-issuers including both depository institutions (by 25 bps) and bank holding companies (by 50 bps). The incrementally generated fees are expected to assist with replenishing the DIF. The current TLGP fee schedule is presented below:

It is curious that the FDIC is using the TLGP, which was supposed to be a sacrosanct debt issuance guarantee, as a cash cow to salvage its core deposit insurance product. And as always, the law of unintended consequences rears its ugly heads... But before getting to that, just how much debt has been issued under TLGP and what fees has it generated so far?According to the FDIC, at January 31, 2009, there was $253 billion in insured debt outstanding under the TLGP, and since then at least another $50 billion of FDIC-backed debt has been issued based on market data. This roughly $300 billion amount has translated in approximately $4.5 billion in fees through January, and Bank of America estimates that February and March added another $1 billion in fees. Thus, the FDIC has collected roughly $5.5 billion, or 2% on the $300 billion it currently guarantees under TLGP.

It is obvious that even with the $3.5 billion generated via TLGP issuance in Q4, the rapid decline in the DIF is unlikely to be dented at all via any adjustments to the fee structure on new guaranteed debt, although this is just the route that Sheila Bair seems to have set out on. However, under the advice of Perella Weinberg, she must realize the futility of this action, which would explain the March 5 bill proposed by Senate Banking Committee Chairman Chris Dodd...

The Depositor Protection Act of 2009

In a very aptly named bill (full text here), Chris Dodd proposes a massive overhaul to the capitalization of the FDIC, so much so that it would make the limitations on the widely criticized TARP seem like child's play (with all the staged bellyaching in both Senate and Congress of how banks will not get even a penny more in bailout funding). Dodd, cunningly, is proposing adjustments to Treasury borrowing limit by the FDIC under the pretext that it will benefit depositors, when in actuality it is only bank holding companies and further TLGP issuers that will be the sole beneficiaries of this bill. The DPA 2009 effectively increases the implicit bailout capital available to banks by up to half a trillion! The terms of Dodd'sDPA 2009 are presented below:

It looks like quite soon, with the blessing of the Godfathers of bailout enabling Geithner and Bernanke, the DPA 2009 will be a fact, more failing banks will become subsidized by taxpayers, and another half a trillion will have to be raised in the Treasury market, adding to the already significant backlog of over $2 trillion in new TSYs which the U.S. is praying can find a home both domestically but mostly in China. On the flipside, when (not if) this legislation passes, the FDIC should be able to rescind the incremental and totally useless fees it is planning on levying to issuer banks. Which brings us to the topic of...

Law Of Unintended Consequences

When the news of the proposed 25 and 50 bps increase in FDIC fees hit the market, there was a dramatic sell off in the secondary market of existing TLGP issues, demonstrated by widening spreads as investors expected a surge in issuance ahead of April 1, when the new fee structure is implemented.

This substantial widening has the potential to destabilize a majority of the to date efforts implemented in shoring up confidence in the credit system, especially the financial term markets.

Another troubling unintended consequence has to do with the term distribution of fixed-rate TLGP debt, which based on FDIC data, tends to be clustered around the 2-3 year mark.

When this fixed-rate debt is swapped back to floating, there tends to be pressure on 2 yr and 3 yr spreads to tighten. This has been empirically proven: 2 yr spreads have tightened dramatically over the past several days, coincident with a sharp uptick in TLGP issuance. Assuming TLGP issuance remains elevated until the end of March, ahead of the April 1 new fee schedule, swapping flows will keep short spreads abnormally tight. Then, once we enter April, spreads will be driven wider by the dramatic drop in TLGP swapping activity from reduced issuance.

And the last unintended consequence will likely implicate the much suffering LIBOR: as banks become TLGP-issuance averse and seek to borrow in the pro forma cheaper Eurodollar market, LIBOR is likely to spike and short spreads to widen. The threat of a widening LIBOR is perfectly evident just by looking at its trading levels over the past 10 days as banks have already starting looking at Eurodollar conduits as an alternative to TLGP.

The increase in LIBOR rates will have a cascading impact on a plethora of other credit market viability metrics, such as the mundane and mainstream media favorite Ted-spread, to the much more sneaky, under-the-radar and significantly more critical to term liquidity LIBOR-OIS spread.

Lastly, as the name implies, every action that the administration can and will come up with to postpone the inevitable day of reckoning for its cheap-liquidity addicted, zombie bank patients, will surely have even more unintended, unforeseen and definitely negative consequences.

Summary

There is nothing that can be done at this point to prevent the administration from leeching every last dollar out of its taxpayers to benefit the terminally addicted and zombied bank system. Using pretexts, subterfuge and lies, the administration's charade triage will only end once there are no more gullible taxpayers to provide their cash, no more demagogue senators and congressmen who will bend reality to make it seem that their actions benefiting a select few are for the benefit of all, and no more naive investors who buy into the promises that U.S. debt is the "safest investment." However, for the scope of this post, I can only hope that Perella Weinberg quickly realizes the futility of the TLGP fee increase, and that the goals of that particular action will be magnified when Dodd's hilariously titled DPA 2009 bill passes, as the negative consequences are likely to substantially surpass any positive ones.

In the grand scheme of things, at this point it doesn't really matter: at best, any FDIC action buys the U.S. financial system a year or so to delay the inevitable moment when the heroin addict decides it is time to seek the help of a methadone clinic before it is too late, only to realize that in its quest to feed the addiction, the administration forgot to provision for any precious methadone... but then again its availability would imply someone actually believes U.S. banks will, at some point, get to a point where detox is even a remote possibility which is obviously not the case (at least for now).

And if the unimaginable does happen, and the administration does comprehend that the wisest and correct thing is to use the cold turkey approach on U.S. financials, Zero Hedge provides some more sage advice from the protagonist of Trainspotting, who succeeded where so many U.S. banks have and will fail:

Relinquishing junk. Stage one, preparation. For this you will need one room which you will not leave. Soothing music. Tomato soup, ten tins of. Mushroom soup, eight tins of, for consumption cold. Ice cream, vanilla, one large tub of. Magnesia, milk of, one bottle. Paracetamol, mouthwash, vitamins. Mineral water, Lucozade, pornography. One mattress. One bucket for urine, one for feces and one for vomitus. One television and one bottle of Valium, which I've already procured from my mother, who is, in her own domestic and socially acceptable way also a drug addict. And now I'm ready. All I need is one final hit to soothe the pain while the Valium takes effect.

I believe the greatest insight you have here, and not a new one admittedly, is that of credit junkie. Liabilities exceeding assets is of no consequence for a company that can maintain access to capital. So it goes with the US. As long as our creditors don't force our hand directly via the Treasury market, the illusion will continue. And even then the Fed will put off that reckoning by purchasing Treasuries.

And even then, we have yet to see a soverign default. So far soverigns have been making faces at their creditors from behind silk screens. But when one decides to extend a foreceful middle finger for all to see, US debt will again be in vogue, further delaying any day of reckoning.

So the US officially dipping its toe in the QE waters and a soverign default are more than enough to keep this gravy train going, no matter how imbalanced the system is. Shoot, if corporates are any indication we'll just refinance all we can out to 2012 and have a couple years of flatline before there are any real problems.

Tyler your analyses are presicent and dutifully chronicle our march to "flush day," but you vastly underestimate the capacity for this illusion to be perpetuated.

I'm new to this site, but I immediately added it to my Bookmark Bar. Terrifically insightful commentary and incredible depth of analysis.

This recent article supports my thesis that the number of unintended consequences likely to occur as a result of any new policy is equal to the number of summary bullets on the front page of the document.

Tyler, I am normally a lurker on your site.. but I had to comment on this particular post. Absolutely well written, proof provided.. I am very impressed!

This is what financial journalism used to be!

I am forwarding your site, and this particular commentary to many people.

I do have a request. I only speak for myself, but I have noticed that sites like OptionArmgeddon have tutorials on certain financial concepts. If possible, can you recommend some to those of us who do not have the financial backgrd you do?

Puerto Rico actually has some lessons on what might happen in the US as the banking crisis and recession continue. Puerto Rico has had 3 years of recession, and last year its banks have non-performing loan ratios between 10% and 20%. Residential smortgages and consumer loans took the first wave of defaults. Commercial loans starting defaulting in 2007, and construction loans started defaulting in 2008.

Likewise, Puerto Rico's economic stats are worth reviewing for a look at what might happen to inflation and GDP: 12% inflation and 12% unemployment in 2008, about 2% fall in GDP in 2007 and 2.5% fall in GDP in 2008.

I discovered this blog a few days ago and it's totally changed my thinking. I feel like a Holy Roller taking up Buddhism or something. I the blog is true because it feels so harsh. The only problem is I feel kind of subversive, like maybe I should have been using one of those internet identity disguise thingies or sneaking into a public library wearing a Tom Friedman moustache to log on. But I guess it's too late now, so I'm looking forward to meeting you at the Hope and Change reeducation camp.

I agree that the FDIC can actually learn something from Puerto Rico, so maybe they have justification for going there. The Fed in contrast held an event in Hawaii on the Kohala Coast. I'd like to hear Bernanke justify why they're meeting in a resort city instead of a conference room at a Fed bank.

"Assuming TLGP issuance remains elevated until the end of March, ahead of the April 1 new fee schedule, swapping flows will keep short spreads abnormally tight. Then, once we enter April, spreads will be driven wider by the dramatic drop in TLGP swapping activity from reduced issuance."

Very minor quibble: swap spreads are unlikely to tighten much between now and April as cash libor already starts to rise (as you note), and as traders (presumably like you) recognize the post-April effect of likely reduced TLGP issuance.

Great post.

One other comment: the DPA may be as toxic as the rest of the alphabet stew, but it just might prevent an immediate crash in small-town banking if its passage means that FDIC will drop the recently announced surcharge on all banks. My view is that Sheila Bair announced the shocking surcharge precisely to wake everyone up to the fact that the majority of banks she supervises are about to pay through the nose for the sins of the mega-zombies, and community-bank credit is what keeps Main Street going, not credit as defined in the wholesale markets in which wall street deals.

I believe that this sickness spreads all over the globe. But we can say that at some places its intensity is less as compared to others. But it is certain that this sickness exists and continues to scare people of its aftermaths for several months to come.Wamu Online Banking